Traditionally, liquid funds have been the plain Jane of the debt funds category; it is the more volatile categories like long bond funds or eventful ones like credit risk funds that have attracted more attention. However, recent events have put liquid funds under the spotlight.

It all started with the IL&FS default. While fund houses have had exposure to IL&FS across fund categories (liquid, credit risk funds or FMPs), the actual pain started when liquid funds gave negative returns. Two liquid funds, one with 10% exposure to IL&FS and the other with 2% exposure did a complete provisioning (i.e. write-off) and consequently these two liquid funds gave negative returns. The one with 10% exposure to IL&FS group showed negative returns for more than past one year and the one with 2% exposure showed last  three-month return as negative. This is quite remarkable for the liquid category of funds, which are the safest, as mark-to-market component i.e. variability with market movement, is either zero or negligible.

To compound matters, post IL&FS default, there was a massive exodus from liquid funds in September. Net outflow from liquid funds in September was Rs.2.11 lakh crore, the highest ever. It was not just about advance tax payments which happen every quarter, but the fear psychosis of (a) IL&FS default and (b) certain NBFCs, particularly housing finance companies (HFCs). However, post September, net outflows have turned into net inflows as sentiment is stabilizing. In October, the MF industry recorded a net inflow of Rs.55,296 crore and in November the net inflows improved to Rs.1.36 lakh crore.

In a way, the corpus loss of September is almost recouped through October and November. Driven largely by better portfolio quality and lower exposure to NBFCs, the inflows were concentrated into a few large AMCs.

The other aspect of liquid funds is the discussion at SEBI about (a) mark-to-market of the portfolio and (b) exit load. Let’s see what these are. For daily NAV purposes, the mark-to-market of debt and money market instruments are done as per the valuation level given by independent agencies, CRISIL and ICRA. The valuation guideline given by these agencies are of instruments with residual maturity more than 60 days. This means, for instruments of maturity less than 60 days, the valuation is mostly on accrual basis, unless something extreme happens.

Reportedly, SEBI is thinking in lines of reduction of minimum maturity for MTM purposes from 60 days. Here it remains to be seen, to what extent it is reduced. Currently, most liquid funds hold instruments of maturity less than 60 days, though rules permit upto 91 days. If 60 days is reduced to 30 days, liquid funds will mostly hold instruments of maturity less than 30 days, which will make it even more defensive. If 60 days is reduced to 1 day, then there will be some volatility in liquid fund returns and overnight funds will gain popularity.

Now coming to exit load, liquid funds are cash management products, where inflows and outflows happen on a one-day basis. If an exit load is imposed, it is inimical to the concept of liquid funds. If the purpose is to reduce volatility i.e. large inflows / outflows happening, thus putting pressure on AMCs because the underlying market is not liquid.

There is another way of doing it. The maximum investment per investor in a fund is 25% of the fund corpus, which is defined as a unique entity as per PAN and other KYC documents. For this purpose, different companies in the same business group are different entities. If the maximum limit is reduced from 25% to such a level as SEBI thinks fit, the purpose will be served and the nature of liquid funds will be preserved.

Source: https://cafemutual.com/news/guestcolumn/361-what-to-expect-from-liquid-funds-in-2019